The worry with high frequency trading

Richard Livingston

Following intense media coverage, including calls from the likes of Alan Kohler to "cut the pipes" — the fibre-optic cables linking traders to the stock exchange — last month the Minister for Financial Services and Superannuation, Bill Shorten, announced new "market integrity rules" to apply to high frequency trading (HFT).

The new rules include a requirement for "kill switches" — to stop computer trading if required — and obligations, on stock exchange operators and participants, to monitor large price movements and enforce new measures if they occur.

This week, the Financial Services Council released a report supporting these measures. That's the signal for retail investors to start worrying about what they're up for.

HFT is a subset of algorithmic trading, which uses powerful computers to trade shares at incomprehensible speeds. The typical algorithmic trader might use a complicated formula to trade based on brief movements in the relationship between certain securities, whereas the HFT trader focuses on pure speed. This allows them, for example, to grab an unfilled sell order when some good news is released.

Critics liken the practice to front-running, which is illegal, but consider this: If you've got a BHP sell order in the market and news is announced that is likely to push the share price up, you're going to lose out to anyone faster than you.

What the HFT trader does is take money from the next fastest trader, not you. Yes, there is likely to be some mischief occurring (in finance there always is), but high frequency trading isn't the threat to retail investors it's made out to be.

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If you are holding shares for the long term, it will have negligible or no impact on you. Why? Because HFT traders profit from conducting a large number of trades with tiny profits on each one. The small "cost" they impose is on those trading frequently but not quickly. That discounts the vast majority of retail investors.

So why all the hysteria? It's quite possible that the fast, but not fastest, traders have whipped up the media on the issue to level the playing field.

But even if you are a high volume retail investor, you won't necessarily benefit from more regulation.

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New rules might also restrict other forms of algorithmic trading, which can work to your benefit by reducing spreads or increasing liquidity. And the price you pay for increased regulation may end up outweighing the benefits. Financial planning clients know this all too well.

What should be done, if anything?

HFT specialist Fil Mackay of Vertigo Technologies works with non-geeks to help them understand HFT and what it costs them.

He says that our current market rules, which give priority to the first person to match a posted order, are to blame. The incentive is to be fast in, best dressed. His alternative, TimeMatch, auctions orders individually by price, removing the time-based advantage.

The entire issue is a bit like the Salem witch trials. Everyone is seeking a solution to a problem they can neither identify nor explain.

That's a bad basis for new rules and regulations. Inevitably, it brings all sorts of unintended

consequences. Retail investors should be worried that they're about to pay a high price to address a problem that, for them, isn't really a problem at all.

Richard Livingston is the managing director of Intelligent Investor Super Advisor, an online service providing SMSF and investing advice. This article contains general investment advice only (under AFSL 282288).